We are grateful to John Campbell, Bernard Dumas, Hyun Shin, Narayana Kocherlakota, and two anonymous referees for comments on a previous draft. Financial support from the National Science Foundation (grant SES-0649442), the Bankard Fund for Political Economy, and the National Centre of Competence in Research “Financial Valuation and Risk Management” (NCCR FINRISK) is gratefully acknowledged.
Higher Order Expectations in Asset Pricing
Article first published online: 19 JUL 2008
© 2008 The Ohio State University
Journal of Money, Credit and Banking
Volume 40, Issue 5, pages 837–866, August 2008
How to Cite
BACCHETTA, P. and VAN WINCOOP, E. (2008), Higher Order Expectations in Asset Pricing. Journal of Money, Credit and Banking, 40: 837–866. doi: 10.1111/j.1538-4616.2008.00139.x
- Issue published online: 19 JUL 2008
- Article first published online: 19 JUL 2008
- Received December 9, 2005; and accepted in revised form December 31, 2007.
- higher order beliefs;
- beauty contest;
- asset pricing
We examine formally Keynes' idea that higher order beliefs can drive a wedge between an asset price and its fundamental value based on expected future payoffs. We call this the higher order wedge, which depends on the difference between higher and first order expectations of future payoffs. We analyze the determinants of this wedge and its impact on the equilibrium price in the context of a dynamic noisy rational expectations model. We show that the wedge reduces asset price volatility and disconnects the price from the present value of future payoffs. The impact of the higher order wedge on the equilibrium price can be quantitatively large.